Saving for a teenager's retirement might sound far-fetched to parent and child alike, especially with college costs looming. Who's got time or money to be planning for the 2060s?
Yet setting up a Roth individual retirement account for your teen can be a smart and rewarding move to consider at tax time. You don't have to be rich to do it, either.
It makes good sense to set aside money that can grow many times over by the time it's put to use. And establishing an IRA with a teen's own cash — perhaps supplemented by Mom and Dad or the grandparents — can convey a powerful financial message that no pep talk could match.
"It provides an opportunity to engage a generation that typically doesn't focus much on investing with something that's theirs," says John Heywood, a principal in Vanguard's retail investor group.
A Roth IRA differs from a traditional IRA in that you contribute with after-tax money but pay no taxes on withdrawals, meaning all growth is tax-free.
As with Roths for adults, not every teen qualifies and there are strict rules to follow.
You can only open one if the child has income from a job — allowances don't count. You can't contribute more than the child made in any given tax year, up to the limit of $5,000. And if you want to apply the teen's earnings from bagging groceries or waitressing last summer, the deadline for making 2009 IRA contributions is April 15.
If you are self-employed, you can employ your children, pay them a salary and open a Roth on their behalf. Just make sure they do real work for a reasonable wage and you file W-2 forms reporting their earnings to the Social Security Administration.
Leslie Beck of Cupertino, Calif., and her husband Doug started a Roth for their then-16-year-old daughter Diana in 2008 and insisted she contribute $3,000 of her $6,200 in income to the account while also setting aside money for college.
Leslie had the clout of being not only mom but boss, hiring Diana to do filing and administrative work for her investment management firm after school. She also promised to match Diana's contributions dollar-for-dollar the second year, ultimately giving her $1,500 of "free money" last year.
Still, a retirement account wasn't an easy sell. Her daughter viewed it as a black hole.
Now a freshman at the University of California-Santa Barbara, Diana still is hardly thinking about retirement. But she acknowledges her mom's idea wasn't a bad one.
"With times as tough as they are, you know — it isn't too early to start saving," she says.
Putting the teen's own money on the line may lessen any temptation to cash the account out early, too, because that would come at a price. Most Roth withdrawals before age 59½ are subject to a 10 percent penalty.
"I wanted her to start saving for retirement as early as possible," Leslie Beck says. "Hopefully it'll be a habit by the time she's 21."
Here are five reasons why a Roth IRA can be a good idea for your teen:
Decades of compounding
Long-term compounding, or generating earnings from previous earnings, won't necessarily make your kid a millionaire. But it could with future contributions.
Consider a hypothetical case in which $2,000 is put in a Roth annually for four years — each year of high school, for example.
Assuming the money grows at an annual rate of 8 percent, the account would total about $456,000 in 50 years when the teen has reached retirement age. And if the account-holder faithfully contributes $2,000 at the start of every year for 50 years, it would be worth more than $1.2 million.
In short: It's common for many not to establish an IRA until their 30s or even later; starting at 16 or 17 allows decades of earning interest on interest.
"The real benefit of this is using the power of compounding to its maximum," says Rob Seltzer, a financial adviser in Beverly Hills, Calif.
Starting to save early for retirement is more important than ever at a time when the classic three-legged stool approach to retirement security — employer pension, Social Security and personal savings — is teetering.
Employer pensions are vanishing so fast that no young person should expect to have one. The number of workers with a company-provided pension fell to 15 percent in 2008 from 40 percent in 1975, according to the Employee Benefit Research Institute.
And who knows how much anyone will be able to count on Social Security in half a century?
When first entering the work force, many college graduates focus on paying off their student loans. Starting retirement savings in their teens, even if they aren't able to contribute for a number of years, at least puts some money to work early.
Committing to a Roth doesn't automatically lock up the money for decades. Once the account has been open five years, up to $10,000 can be withdrawn penalty-free if it's put toward the purchase of a first home.
Good habits taught
Educating your teenager about the value of compounding interest and saving early could be a lasting legacy if it fosters good habits.
Teaching young people to put money aside regularly in a retirement account and other financial needs buckets helps them be better prepared for various life stages.
"When people learn about techniques like budgeting or dollar-cost averaging or making periodic payments into an account early in life, that is a great way to have them save for the long run," says Chuck Toth, director of product management for Bank of America Merrill Lynch.
A teenager working part-time will have one of the lowest tax rates, making it a good trade-off to pay taxes on contributions now rather than accumulated retirement savings in a few decades when the total and the tax rate will be much higher.
The tax-free withdrawals allowed with Roths mean having an account is a double winner for a young person in terms of taxes.
Contribution need not be large
Contributing the yearly maximum of $5,000 to a teen's Roth, or even $2,000, just isn't feasible for most families. But small amounts are fine too. Even a few hundred dollars can start snowballing into significant money by retirement time, especially once you've set up the account and made it easier to save in future years.
"It's an interesting and attractive way to save regardless of the amount," says Heywood of Vanguard.